Stephen Bainbridge's Journal of Law, Religion, Politics, and Culture

Wall Street Reform

12/31/2018

Bloomberg reports that there is some interest on a bipartisan basis in a Jobs 3.0 bill that would include provisions:

...intended to help companies bring in more capital through initial public offerings and certain investors.

The legislation, for example, would enlarge the group of “accredited investors” who can take part in some unregistered securities offerings, ease startup fundraising involving “angel investors,” and allow all corporations — not just emerging-growth companies — greater freedom to talk to investors and “test the waters” about their potential IPOs.

But there's some stuff missing (granted some of these would be more controversial political):

Securities fraud reform.Our expansive securities anti-fraud legal regime poses serious risks to the competitiveness of our markets. Noting that virtually all states now allow corporations to adopt charter provisions limiting director and officer liability and observing that corporate law properly consists of a set of default rules the parties generally should be free to amend, I have proposed allowing corporations to adopt provisions in their articles of incorporation to opt out of derivative litigation and/or securities class actions.

Shifting to a more flexible principles-based securities law system from the current rules-based one.

Comprehensively reviewing the governance provisions of Sarbanes-Oxley and Dodd-Frank to determine whether there are some that are imposing undue burdens.

12/07/2018

On a party-line vote, the Senate approved Kathy Kraninger for a five-year term as the head of the Consumer Financial Protection Bureau. You will recall, of course, that many of us were critical of the structure of the CFPB, which Senator Warren in her infinite wisdom basically structured so as to be unaccountable to either the President or Congress. That particular decision has now come back to bite her in the proverbial Biblical beast of burden, as Bloomberg Law reports:

Consumer advocates and Democratic lawmakers fear that Kraninger will go farther than periodically skipping funding draws from the Fed. They worry that Kraninger will attempt to enact a proposed Trump administration fiscal 2019 budget that she helped write while she was at the Office of Management and Budget. As the CFPB’s director, Kraninger would be able to enact a proposed $147 million cut, about 23 percent of the the bureau’s budget, on her own and without any input from Congress.

The lesson is never to assume that your acolytes will be in charge permanently.

The Accountable Capitalism Act [that she recently introduced in Congress] ... would give workers a stronger voice in corporate decision-making at large companies. Employees would elect at least 40% of directors.

In effect, she would mandate a version of codetermination. Early in my career I wrote a series of articles explaining why employee involvement in corporate governance is a fundamentally bad idea:

In my (sadly out of print) book Corporation Law and Economics, my analysis of corporate voting rights begins by showing that public corporation decisionmaking must be conducted on a representative rather than participatory basis. It further demonstrates that only one constituency should be allowed to elect the board of directors. It then turns to the question of why shareholders are the chosen constituency, rather than employees. In this blog post, I focus on the latter issue, since that it the key issue raised by Warren's bill.

The standard law and economics explanation for vesting voting rights in shareholders is that shareholders are the only corporate constituent with a residual, unfixed, ex post claim on corporate assets and earnings.[1]In contrast, the employees’ claim is prior and largely fixed ex ante through agreed‑upon compensation schedules. This distinction has two implications of present import. First, as noted above, employee interests are too parochial to justify board representation. In contrast, shareholders have the strongest economic incentive to care about the size of the residual claim, which means that they have the greatest incentive to elect directors committed to maximizing firm profitability.[2]Second, the nature of the employees’ claim on the firm creates incentives to shirk. Vesting control rights in the employees would increase their incentive to shirk. In turn, the prospect of employee shirking lowers the value of the shareholders’ residual claim.

At this point, it is useful to once again invoke the hypothetical bargain methodology. If the corporation’s various constituencies could bargain over voting rights, to which constituency would they assign those rights? In light of their status as residual claimants and the adverse effects of employee representation, shareholders doubtless would bargain for control rights, so as to ensure a corporate decisionmaking system emphasizing monitoring mechanisms designed to prevent shirking by employees, and employees would be willing to concede such rights to shareholders.

Granted, collective action problems preclude the shareholders from exercising meaningful day-to-day or even year-to-year control over managerial decisions. Unlike the employees’ claim, however, the shareholders’ claim on the corporation is freely transferable. As such, if management fails to maximize the shareholders’ residual claim, an outsider can profit by purchasing a majority of the shares and voting out the incumbent board of directors. Accordingly, vesting the right to vote solely in the hands of the firm’s shareholders is what makes possible the market for corporate control and thus helps to minimize shirking. As the residual claimants, shareholders thus would bargain for sole voting control, in order to ensure that the value of their claim is maximized. In turn, because all corporate constituents have an ex ante interest in minimizing shirking by managers and other agents, the firm’s employees have an incentive to agree to such rules.[3]The employees’ lack of control rights thus can be seen as a way in which they bond their promise not to shirk. Their lack of control rights not only precludes them from double-dipping, but also facilitates disciplining employees who shirk. Accordingly, it is not surprising that the default rules of the standard form contract provided by all corporate statutes vest voting rights solely in the hands of common shareholders.

To be sure, the vote allows shareholders to allocate some risk to prior claimants. If a firm is in financial straits, directors and managers faithful to shareholder interests could protect the value of the shareholders’ residual claim by, for example, financial and/or workforce restructurings that eliminate prior claimants. All of which raises the question of why employees do not get the vote to protect themselves against this risk. The answer is two-fold. First, as we have seen, multiple constituencies are inefficient. Second, as addressed below, employees have significant protections that do not rely on voting.

Suppose a firm behaves opportunistically towards it employees. What protections do the employees have? Some are protected by job mobility. The value of continued dealings with an employer to an employee whose work involves solely general human capital does not depend on the value of the firm because neither the employee nor the firm have an incentive to preserve such an employment relationships. If the employee’s general human capital suffices for him to do his job at Firm A, it presumably would suffice for him to do a similar job at Firm B. Such an employee resembles an independent contractor who can shift from firm to firm at low cost to either employee or employer.[4]Mobility thus may be a sufficient defense against opportunistic conduct with respect to such employees, because they can quit and be replaced without productive loss to either employee or employer. Put another way, because there are no appropriable quasi-rents in this category of employment relationships, rent seeking by management is not a concern.

Corporate employees who make firm-specific investments in human capital arguably need greater protection against employer opportunism, but such protections need not include board representation. Indeed, various specialized governance structures have arisen to protect such workers. Among these are severance pay, grievance procedures, promotion ladders, collective bargaining, and the like.[5]

In contrast, shareholders are poorly positioned to develop the kinds of specialized governance structures that protect employee interests. Unlike employees, whose relationship to the firm is subject to periodic renegotiation, shareholders have an indefinite relationship that is rarely renegotiated, if ever. The dispersed nature of stockownership also makes bilateral negotiation of specialized safeguards difficult. The board of directors thus is an essential governance mechanism for protecting shareholder interests.

If the foregoing analysis is correct, why do we nevertheless sometimes observe employee representation? An explanation consistent with our analysis lies close at hand. In the United States, employee representation on the board is typically found in firms that have undergone concessionary bargaining with unions. Concessionary bargaining, on average, results in increased share values of eight to ten percent.[6]The stock market apparently views union concessions as substantially improving the value of the residual claim, presumably by making firm failure less likely. While the firm’s employees also benefit from a reduction in the firm’s riskiness, they are likely to demand a quid pro quo for their contribution to shareholder wealth. One consideration given by shareholders (through management) may be greater access to information, sometimes through board representation. Put another way, board of director representation is a way of maximizing access to information and bonding its accuracy. The employee representatives will be able to verify that the original information about the firm’s precarious financial situation was accurate. Employee representatives on the board also are well-positioned to determine whether the firm’s prospects have improved sufficiently to justify an attempt to reverse prior concessions through a new round of bargaining.

08/16/2018

As noted in a prior post, Senator Elizabeth Warren has introduced a bill that would require "corporate directors to consider the interests of all major corporate stakeholders—not only shareholders—in company decisions. Unlike state non shareholder constituency statutes, which are merely permissive, her bill would mandate such consideration.

As Stefan Padfield has noted:

There should be no doubt that imposing mandatory consideration of stakeholders on directors in carrying out their oversight responsibilities carries meaningful risk of undermining the wealth creation and innovation benefits of the corporate form as currently constituted.This general criticism has been well vetted elsewhere, and I will not rehash the debate here, though my declining to do so should not be construed as my being dismissive of relevant concerns regarding statism.

Because shareholder wealth maximization is the right rule, as we discussed in the preceding post, mandating that directors consider non-shareholder interests in making corporate decisions is clearly wrong in and of itself.

In contrast, many rules of state corporate law are enabling rather than mandatory. This is efficient because default rules are preferable to mandatory rules in most settings.[1] So long as the default rule is properly chosen, of course, most parties will be spared the need to reach a private agreement on the issue in question. Default rules in this sense provide cost savings comparable to those provided by standard form contracts, because both can be accepted without the need for costly negotiation. At the same time, however, because the default rule can be modified by contrary agreement, idiosyncratic parties wishing a different rule can be accommodated. Given these advantages, a fairly compelling case ought to be required before we impose a mandatory rule.[2] Mandatory rules are justifiable only if a default rule would demonstrably create significant negative externalities or, perhaps, if one of the contracting parties is demonstrably unable to protect itself through bargaining.

The use of mandatory rules at the federal level is particularly deplorable. If a state adopts an inefficient mandatory rule (see, e.g., much of California corporate law) corporations can respond by reincorporating in a state whose law is more enabling. Obviously, however, few corporations will seriously consider shifting their corporate headquarters to another country to avoid inefficient federal corporate laws. (Having said that, of course, many companies might go private (a.k.a. go dark) in response, as many did in response to SOX and Dodd-Frank.)

Unlike Delaware corporate law, which is typically updated annually to correct errors and improve the law, the federal government rarely revisits mistakes like SOX and Dodd-Frank. So we get stuck with bad federal rules.

As noted in a prior post, Senator Elizabeth Warren has introduced a bill that would require "corporate directors to consider the interests of all major corporate stakeholders—not only shareholders—in company decisions.

The Shared Interests of Managers and Labor in Corporate Governance: A Comment on Strine (May 10, 2007). UCLA School of Law Research Paper No. 07-15. Available at SSRN: https://ssrn.com/abstract=985683

Director versus Shareholder Primacy in New Zealand Company Law as Compared to U.S.A. Corporate Law (March 26, 2014). UCLA School of Law, Law-Econ Research Paper No. 14-05. Available at SSRN: https://ssrn.com/abstract=2416449

Corporate Social Responsibility in the Night Watchman State: A Comment on Strine & Walker (September 9, 2014). UCLA School of Law, Law-Econ Research Paper No. 14-12. Available at SSRN: https://ssrn.com/abstract=2494003

In the first place, requiring directors to maximize shareholder wealth provides the board of directors with a determinate metric for making business decisions. I often use the following example to explain what I mean by that: Suppose Acme's board of directors is considering closing an obsolete plant. The board is advised that closing the plant will cost many long-time workers their job and be devastating for the local community. On the other hand, the board's advisors confirm that closing the existing plant will benefit Acme's shareholders, new employees hired to work at a more modern plant to which the work previously performed at the old plant will be transferred, and the local communities around the modern plant. Assume that the latter groups cannot gain except at the former groups' expense. By what standard should the board make the decision?

Shareholder wealth maximization provides a clear answer -- close the plant. Once the directors are allowed to deviate from shareholder wealth maximization, however, they must inevitably turn to indeterminate balancing standards. Such standards deprive directors of the critical ability to determine ex ante whether their behavior comports with the law's demands, raising the transaction costs of corporate governance.

Worse yet, absent the clear standard provided by the shareholder wealth maximization norm, the board of directors will be tempted to allow their personal self-interest to dominate their decision making. Put another way, directors who are allowed to consider everybody's interests end up being accountable to no one.

In the plant closing example, if the board's interests favor keeping the plant open, we can expect the board to at least lean in that direction. The plant likely will stay open, with the decision being justified by reference to the impact of a closing on the plant's workers and the local community. In contrast, if the board of directors' interests are served by closing the plant, the plant will likely close, with the decision being justified by concern for the firm's shareholders, creditors, and other benefited constituencies.

As noted in a prior post, Senator Elizabeth Warren has introduced a bill that would require "corporate directors to consider the interests of all major corporate stakeholders—not only shareholders—in company decisions. Shareholders could sue if they believed directors weren’t fulfilling those obligations."

In a future post, I will take on the task of defending the shareholder wealth maximization norm on the merits.

Here I just want to point out the bizarre enforcement mechanism she's chosen: She wants directors to consider the interest of non-shareholder constituents who making corporate decisions, but if the directors fail to do so it is left to shareholders to sue. That makes no sense.

The problem here is that the decisions that matter are often zero sum ones in which the board must chose between shareholder and non-shareholder interests. After all, if a decision seems likely to lift all boats on a rising tide of corporate success, there are good reasons to respect director discretion. See my blog post on the business judgment rule. (By the way, would Warren allow the business judgment rule to apply to these suits? If not, that just makes it worse.)

So let's imagine a zero-sum decision in which the board has chosen to side with shareholder interests. Presumably, the shareholders are happy and the rational ones will not sue (although some plaintiff lawyer might find a stooge to bring a strike suit so as to extort legal fees from the corporation).

Conversely, imagine a zero-sum decision in which the board has chosen to side with non-shareholder interests. Now the shareholders will be unhappy and the rational ones will sue.

Bottom line? If you think the basic idea of giving directors discretion to consider non-shareholder interests is a good idea, Warren's enforcement proposal gets it exactly backwards. Shareholder standing to sue will to advance stakeholder interests but will only impede those interests.

In an earlier post, I noted that Senator Elizabeth Warren has introduced legislation designed to federalize the law of corporate social responsibility. Among other flaws with her proposal, a key one is the proposal to preempt state corporate law with a federal statute.

The U.S. Supreme Court has held repeatedly that the federal securities laws do not preempt state corporate law, but instead place only a limited gloss on the broader body of state law.[1] A fair rule of thumb is that state law is concerned with the substance of corporate governance, while federal law is concerned with disclosure and a limited number of procedural aspects of corporate governance (such as the solicitation of proxies and the conduct of a tender offer).[2]

The basic case for federalizing corporate law rests on the so-called “race to the bottom” hypothesis. States compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders. As the clear winner in this state competition, Delaware is usually the poster-child for bad corporate governance. Interestingly, the two main corporate failures cited to justify the Sarbanes-Oxley Act, Enron and WorldCom, were not Delaware corporations. (They were incorporated in Oregon and Georgia, respectively.)

The basic case for federalizing corporate law rests on the so-called “race to the bottom” hypothesis. States compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders. As the clear winner in this state competition, Delaware is usually the poster-child for bad corporate governance. Interestingly, the two main poster-children for reform, Enron and WorldCom, were not Delaware corporations. (They were incorporated in Oregon and Georgia, respectively.)

Basic economic common sense tells us that investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not lend to such firms without compensation for the risks posed by management’s lack of accountability. As a result, those firms’ cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from adopting excessively pro management statutes. The empirical research bears out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time.

Roberta Romano’s event study of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive cumulative abnormal returns.[3] In other words, reincorporating in Delaware increased shareholder wealth. This finding strongly supports the race to the top hypothesis. If shareholders thought that Delaware was winning a race to the bottom, shareholders should dump the stock of firms that reincorporate in Delaware, driving down the stock price of such firms. As Romano found, and all of the other major event studies confirm, there is a positive stock price effect upon reincorporation in Delaware.[4]

The event study findings are buttressed by a well-known study by Robert Daines in which he compared the Tobin’s Q of Delaware and non-Delaware corporations. (Tobin’s Q is the ratio of a firm’s market value to its book value and is a widely accepted measure of firm value.) Daines found that Delaware corporations in the period 1981-1996 had a higher Tobin’s Q than those of non-Delaware corporations, suggesting that Delaware law increases shareholder wealth.[5] Although subsequent research suggests that this effect may not hold for all periods, Daines’ study remains an important confirmation of the event study data.

Additional support for the event study findings is provided by takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing ferocity, Delaware’s single takeover statute is relatively friendly to hostile bidders. An empirical study of state corporation codes by John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder.[6] Given the clear evidence that hostile takeovers increase shareholder wealth,[7] this finding is especially striking. The supposed poster child of bad corporate governance, Delaware, turns out to be quite takeover-friendly and, by implication, equally shareholder-friendly.

The takeover regulation evidence is especially important, because state anti-takeover laws are the principal arrow in the quiver of modern race to the bottom theorists. In a series of articles, Lucian Bebchuk and his co-authors point out that state takeover regulation demonstrably reduces shareholder wealth but that most states have nevertheless adopted anti-takeover statutes.[8] Even many advocates of the race to the top hypothesis concede that state regulation of corporate takeovers appears to be an exception to the rule that efficient solutions tend to win out.[9] But so what? Nobody claims that state competition is perfect. The question is only whether some competition is better than none. Delaware’s relatively hospitable environment for takeovers suggests an affirmative answer to that question.

Bebchuk et al.’s arguments in favor of federal preemption, moreover, betray a complete lack of sympathy for—and perhaps even awareness of—the vital relationship between federalism and liberty. In other words, even if Bebchuk could prove that state competition is a race to the bottom, basic federalism principles would still counsel against federal preemption of corporate law. The corporation is a creature of the state, “whose very existence and attributes are a product of state law.” States have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, a state has a legitimate “interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.”[10] In other words, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.

According to the Supreme Court’s CTSdecision, the country as a whole benefits from state regulation in this area, as well. As Justice Powell explained in that case, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country.”[11] So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules.

In contrast, the uniformity imposed by Sarbanes-Oxley will preclude experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed—no “laboratory” of federalism. Instead, we will be stuck with rules that may well be wrong from the outset and, in any case, may quickly become obsolete.

The point is not merely to restate the race to the top argument. Competitive federalism promotes liberty as well as shareholder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes impractical. if one regulator overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, such that exit by the regulated is no longer an option, an essential check on excessive regulation is lost.

Which is precisely what Warren’s bill would do. She would oust the states from their historic role in regulating public corporation governance and lose all of the benefits that flow from competitive federalism.

07/20/2018

A draft executive order targeting a requirement that companies trace their use of minerals from war-torn regions in Africa is the latest sign that Republicans are wasting no time rolling back the Dodd-Frank Act's corporate disclosure provisions. ...

Dodd-Frank authorizes the SEC to revise or temporarily waive the requirements of the rule for up to two years if the president determines it is in the national security interests of the U.S. The commission declined to comment.

At the beginning of September, 70 academics, researchers, journalists, and advocates published a blistering open letter criticizing Dodd-Frank and its backers, asserting that the groups and activists pushing to stop the trade of conflict minerals risk “contributing to, rather than alleviating, the very conflicts they set out to address.” Their campaign “fundamentally misunderstands the relationship between minerals and conflict” in Congo, the signatories said. (Some critics have gone further still, charging that the advocates who sculpted and pushed Dodd-Frank have even misrepresented, in the name of what they see as a greater good, the situation on the ground in Congo.) Two months later, on Nov. 30, the Washington Post published a long investigative feature describing how Dodd-Frank “set off a chain of events that has propelled millions of miners and their families deeper into poverty.”

But the law’s opponents include progressive journalists and academics who say the rule rests on an overly simplistic analysis of a complex crisis. Some say it has done more harm than good to Eastern Congolese mining communities, whose livelihoods are already precarious.

The law has deprived “very vulnerable populations, already very poor people, of their sole means of livelihood,” says Séverine Autesserre, a political science professor at Barnard College and Columbia University, and a former humanitarian aid worker who studies the DRC. “The legislation has actually made the situation worse for these people.”

The SEC is scheduled to hold a roundtable on conflictminerals disclosures tomorrow. When the roundtable was announced, BNA reported that: The matters to be debated include appropriate reporting approaches for the final rule, the cha...

Marcia Narine reports that: Earlier this week the House Financial Services Committee voted to repeal the Dodd-Frank ConflictMinerals Rule, which I last wrote about here and in a law review article criticizing this kind of disclosure ...

From the Washington Legal Foundation: On March 17, 2017 WLF filed comments with SEC in response to Acting Chairman Piwowar’s January 31 request for input on the ConflictMinerals Rule. WLF seeks repeal of the rule, which implements § ...

Can corporations engage in civil disobedience and, if so, on what issues should they do so? Securities lawyer David Fisher points to conflictminerals disclosure as a case study: "An Act to promote the financial stability of the Unite...

Broc Romanek: Last Friday, the SEC extended the deadlines for submitting comments on a trio of Corp Fin proposals: conflictminerals, mine safety and resource extraction disclosure. The new deadline is March 2nd. Last year, I blogged s...

03/18/2018

FOR years, discussions of America’s public markets have usually featured a lament for their dwindling appeal. According to Jay Ritter of the University of Florida, the number of publicly listed companies peaked in 1997 at 8,491 (see chart). By 2017 it had slumped to 4,496. True, many of the companies that went public in the internet’s early days should never have done so. But the decline worries anyone who sees public markets as the best way for ordinary investors to benefit from the successes of corporate America.

The mood right now is more buoyant. ... “There are plenty of signs that IPO activity is about to surge,” says Kathleen Smith of Renaissance Capital, a research firm.

The question is whether one quarter a revival makes. ...

Underlying these concerns is an older one—that the vast and varied costs of first bringing shares to market, and then remaining public, are just too high. These costs include bankers’ and lawyers’ fees, the risk of class-action litigation, the need to reveal commercially sensitive information that could benefit rivals, and the prospect of fights with corporate raiders who want juicier returns for shareholders and social activists who want executives to pay heed to their values. Added to all these are public reporting and tax requirements that private companies can often avoid.

Mr Ritter attributes much of the decline in the number of companies that are listed to the difficulty of being a small public company.

Hello? Haven't I been saying that for years? See, e.g., Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-13. Available at SSRN: https://ssrn.com/abstract=1696303

This essay was prepared for a forthcoming book on the impact of law on the U.S. economy. (The American Illness: Essays on the Rule of Law) It focuses on the impact the corporate governance regulation has had on the global competitive position of U.S. capital markets.

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

01/30/2018

The Securities and Exchange Commission, in its long history, has never allowed companies to sell shares in initial public offerings while also letting them ban investors from seeking big financial damages through class-action lawsuits. That's because the agency has considered the right to sue a crucial shareholder protection against fraud and other securities violations.

But as President Donald Trump's pro-business agenda sweeps through Washington, the SEC is laying the groundwork for a possible policy shift, said three people familiar with the matter. The agency, according to two of the people, has privately signaled that it's open to at least considering whether companies should be able to force investors to settle disputes through arbitration, an often closed-door process that can limit the bad publicity and high legal costs triggered by litigation.

One can already hear the howls from the plaintiff's bar and their allies in certain institutional investor sectors, but this is an idea whose time has come.

The current system of securities class‐action litigation is an inefficient means to redress the harm to investors. Prominent studies have concluded that securities class‐action litigation fails to compensate adequately those harmed by fraud. The median ratio of settlement amount to total alleged investor loss has ranged between two and three percent. Securities classaction lawsuits are essentially wealth transfers among shareholders and often are circular in nature. Existing shareholders bear the burden of compensating aggrieved shareholders, some of whom also may be existing shareholders.

Although individual class members receive relatively little of the ultimate recovery that is spread across a class, the plaintiffs’ attorneys receive customarily twenty to twenty‐five percent of the total recovery. During the past ten years, plaintiffs’ lawyers, along with other middlemen, have obtained nearly $17 billion in fees from securities class actions. The diffused investors in the class lack the ability to bargain over attorney fees and courts rarely reduce the fees proposed by the plaintiffs’ attorneys.

In class‐action litigation, the interests of the plaintiffs’ attorneys and class members may not be aligned in some instances. The plaintiffs’ attorneys bear the full costs of pursuing the litigation but receive only a portion of the ultimate award. Consequently, the decisions of the plaintiffs’ attorneys may be driven by concern over litigation costs and personal gain rather than by an interest in obtaining the best result for class members. Indeed, the recent scandals involving plaintiffs’ attorneys paying large sums to repeat plaintiffs illustrate how class‐action litigation can be abused at the expense of harmed investors.

Companies and their shareholders incur enormous costs to defend against securities class‐action lawsuits. In one recent study, approximately forty‐one percent of the companies listed on the major stock exchanges had been named as defendants in at least one federal securities class action. The total monetary value of securities class‐action settlements in 2008 was $3.09 billion. The average settlement value from 2002 to 2008 was $45.6 million, which represents approximately a 175% increase from the average value of $16.6 million from 1996 to 2001.

Private securities litigation has become a real concern, particularly for new businesses that do not have the resources to handle a large lawsuit. A major lawsuit could sound the death knell for new companies that already bear a disproportionate amount of the total business tort costs in the United States. Although small companies account for nineteen percent of business revenue in the United States, they bear sixty‐nine percent ($98 billion) of the business tort costs. To cope with the cost of securities litigation, companies must raise the prices of their goods and services. Doing so, in turn, logically harms the competitiveness of U.S. businesses in a global marketplace that is dominated by low‐cost goods and services in the nations where providers do not face such threats.

Securities class actions impose a competitive disadvantage on U.S. capital markets relative to markets in other countries. Indeed, foreign companies are reluctant to list in U.S. markets due to concerns with the American litigation system. According to the Committee on Capital Markets Regulation - an independent, bipartisan body composed of twenty‐two corporate and financial leaders from business, finance, law, accounting, and academia - since the late 1990s the percentage of the world’s Initial Public Offerings (IPOs) conducted in the United States has dropped from forty‐eight percent to six percent in 2005. Of the world’s twenty‐five largest IPOs in 2005, only one of them took place in the United States. That trend continued in 2006, when a report dated November 30 observed that, in the year to date, nine of the ten largest IPOs had occurred in markets outside of the United States. Dollar figures are also staggering: Between 2000 and 2005, the percentage of dollars raised in global IPOs in the United States decreased by a factor of ten, dropping from fifty percent to five percent.

Where is the IPO activity going? The Committee report states that over the same time, London’s share of the global IPO market nearly quintupled from five percent to almost twenty‐five percent. United States exchanges attracted only about one‐third of the share of the global IPO volume in 2006 that they had in 2001 and only three of the twenty largest IPOs of 2008 were listed on U.S. stock exchanges. In 2009, the United States regained the global lead in amount of funds raised in IPOs, boasting a robust twenty‐seven percent share of global capital raised. But this number may be of little comfort when one considers that the share is mostly attributed to the $19.6 billion Visa IPO - the largest IPO in U.S. capital market history. Looking beyond this single outlier, it is apparent that capital formation has moved overseas in droves.

An unwieldy class‐action regime impacts not only the market for public offerings, but also the market for private offerings. The success of the venture capital industry relies, in large part, on how readily a start‐up or other privately held company can be taken public. Absent a desire to access the public equity markets in the United States, the amount of private equity activity in the United States also suffers. In contrast to federal litigation, securities arbitration appears to provide a more efficient and cost‐effective mechanism to resolve disputes with integrity while minimizing the burdens on our judicial system. Arbitration ensures that all relevant facts are presented to the panel without the evidentiary hurdles of federal court. In addition, the use of arbitrators knowledgeable about the securities industry may reduce the uncertainty of resolving securities claims in jury trials.

Bondi, Bradley J., Facilitating Economic Recovery and Sustainable Growth through Reform of the Securities Class-Action System: Exploring Arbitration as an Alternative to Litigation (2010). Harvard Journal of Law and Public Policy, Vol. 33, pp. 607-638, 2010. Available at SSRN: https://ssrn.com/abstract=1601305

11/03/2017

Despite controlling both houses of Congress and the Presidency, the GOP has accomplished very little other than getting Gorsuch onto the Supreme Court. In particular, they've failed to reform Dodd-Frank and Sarbanes-Oxley. Granted, the House passed a bill, but the Senate killed it.

The prospects for reforming federal corporate governance law have further dimmed with the announcement that House Financial Services chairman Jeb Hensarling will retire at the end of this Congress. Without his leadership, it seems unlikely that the next Congress will have any greater success.

09/13/2017

The strongest argument against dual class stock rests on conflict of interest grounds. There is good reason to be suspicious of management's motives and conduct in certain mid-term dual class recapitalizations.[1] Dual class transactions motivated by their anti-takeover effects, like all takeover defenses, pose an obvious potential for conflicts of interest. If a hostile bidder succeeds, it is almost certain to remove many of the target's incumbent directors and officers. On the other hand, if the bidder is defeated by incumbent management, target shareholders are deprived of a substantial premium for their shares. A dual class capital structure, of course, effectively assures the latter outcome.

In addition to this general concern, a distinct source of potential conflict between managers' self-interest and the best interests of the shareholders arises in dual class recapitalizations. An analogy to management-led leveraged buyouts ("MBOs") may be useful. In these transactions, management has a clear-cut conflict of interest. On the one hand, they are fiduciaries of the shareholders charged with getting the best price for the shareholders. On the other, as buyers, they have a strong self-interest in paying the lowest possible price.

In some dual class recapitalizations, management has essentially the same conflict of interest. Although they are fiduciaries charged with protecting the shareholders' interests, the disparate voting rights plan typically will give them voting control. The managers' temptation to act in their own self-interest is obvious. Yet, unlike MBOs, in a dual class recapitalization, management neither pays for voting control nor is its conduct subject to meaningful judicial review. As such, the conflict of interest posed by dual class recapitalizations is even more pronounced than that found in MBOs.

While management's conflict of interest may justify some restrictions on some disparate voting rights plans, it hardly justifies a sweeping prohibition of dual class stock. First, not all such plans involve a conflict of interest. Dual class IPOs are the clearest case. Public investors who don't want lesser voting rights stock simply won't buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate. In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off is offered by the firm in recompense. In effect, management's conflict of interest is thus constrained by a form of market review.

Another good example of a dual class transaction that fails to raise conflict of interest concerns is subsequent issuance of lesser-voting rights shares. Such an issuance does not disenfranchise existing shareholders, as they retain their existing voting rights. Nor are the purchasers of such shares harmed; as in an IPO, they take the shares knowing that the rights will be less than those of the existing shareholders. For the same reason, issuance of lesser-voting rights shares as consideration in a merger or other corporate acquisition should not be objectionable.

Second, even with respect to those disparate voting rights plans that do raise conflict of interest concerns, it must be recognized that there is only a potential conflict of interest. Despite the need for skepticism about management's motives, it is worth remembering that "having a 'conflict of interest' is not something one is 'guilty of'; it is simply a state of affairs."[2] That the board has a conflict of interest thus does not necessarily mean that their conduct will be inconsistent with the best interests of any or all of the corporation's other constituents. To the contrary, the annals of corporate law are replete with instances in which managers faced with a conflict of interest did the right thing.[3] The mere fact that a certain transaction poses a conflict of interest for management therefore does not justify a prohibition of that transaction. It simply means that the transaction needs to be policed to ensure that management pursues the shareholders' best interests rather than their own.

09/09/2017

Dual class stock is back in the news. Institutional investors are seeking ways to delegitimize this governance structure, with some success as reported by the Council of Institutional Investors:

Following the egregious no-vote IPO of Snap Inc. and requests by CII and other concerned investor groups, three major index providers opened public consultations on their treatment of no-vote and multi-class structures. The FTSE Russell consultation resulted in a decision to exclude past and future developed market constituents whose free float constitutes less than 5 percent of total voting power. S&P Dow Jones' consultation resulted in a broader, but only forward-looking exclusion, which bars the addition of multi-class constituents to the S&P Composite 1500 index and its components, covering the S&P 500, MidCap 400 and SmallCap 600 indexes. MSCI's consultation concluded on August 31; a decision remains pending.

I find this hysteria vastly overblown, as I shall explain in a series of posts. Today, I begin by setting the background through a review of the relevant history. As we shall see, dual class capital structures are not an historical anomaly. Rather, it is prohibitions on them that are the oddities.

Famed oilman and takeover raider T. Boone Pickens once asserted that "equal voting rights and common stock ownership are inextricably linked. Over 200 years of experience have established equal voting rights as a fundamental tenet of American democracy."[1] Pickens' rhetorical powers are considerable, but in this case his grasp of economic history was not. Worse yet, his claim is a common misconception.

In fact, however, one share-one vote is not the historical norm. To the contrary, limitations on shareholder voting rights in fact are as old as the corporate form itself.

Prior to the adoption of general incorporation statutes in the mid-1800s, the best evidence as to corporate voting rights is found in individual corporate charters granted by legislatures. Three distinct systems were used. A few charters adopted a one share-one vote rule.[2] Many charters went to the opposite extreme, providing for one vote per shareholder without regard to the number of shares owned.[3] Most followed a middle path, limiting the voting rights of large shareholders. Some charters in the latter category simply imposed a maximum number of votes to which any individual shareholder was entitled. Others specified a complicated formula decreasing per share voting rights as the size of the investor's holdings increased. These charters also often imposed a cap on the number of votes any one shareholder could cast.[4]

Gradually, however, a trend towards a one share-one vote standard emerged.[5] Maryland's experience was typical of the pattern followed in most states, although the precise dates varied widely.[6] Virtually all charters granted by the Maryland legislature between 1784 and 1818 used a weighted voting system. After 1819, however, most charters provided for one vote per share, although approximately 40 percent of the charters granted between 1819 and 1852 retained a maximum number of votes per shareholder. Finally, in 1852, Maryland's first general incorporation statute adopted the modern one vote per share standard.

Legislative suspicion of the corporate form and fear of the concentrated economic power it represented probably motivated the early efforts to limit shareholder voting rights.[7] A variety of factors, however, combined to drive the legal system towards the one share-one vote standard. Because reform efforts were almost invariably led by corporations, apparently under pressure from large shareholders,[8] it may be assumed that one factor was a desire to encourage large scale capital investment. The ease with which restrictive voting rules could be evaded also undermined the more restrictive rules. Large shareholders simply transferred shares to strawmen, for example, who thereupon voted the shares as the true owner directed.[9] Finally, while other factors also contributed, the most important factor probably was the fading of public prejudice towards corporations.[10]

By 1900, a majority of U.S. corporations had moved to one vote per share.[11] Indeed, contrary to present practice, most preferred shares had voting rights equal to those of the common shares.[12] State corporation statutes of the period, however, merely established the one share-one vote principle as a default rule.[13] Corporations were free to deviate from the statutory standard,[14] and the trend towards one vote per share reversed in the first two decades of the 20th Century as a growing number of issuers adopted dual class governance structures.

Two distinct deviations from the one share-one vote standard emerged in the years prior to the Great Crash. One involved elimination or substantial limitation of the voting rights of preferred stock. In particular, it became increasingly common to give preferred shares voting rights only in the event of certain contingencies (such as non-payment of dividends). While controversial at the time,[15] this practice is the modern norm.[16]

The more important development for present purposes was the emergence of nonvoting common stock. One of the earliest examples was the International Silver Company, whose common stock (issued in 1898) had no voting rights until 1902 and then only received one vote for every two shares.[17] After 1918, a growing number of corporations issued two classes of common stock: one having full voting rights on a one vote per share basis, the other having no voting rights (but sometimes having greater dividend rights).[18] By issuing the former to insiders and the latter to the public, promoters could raise considerable sums without losing control of the enterprise.[19]

While disparate voting rights plans were gaining popularity with corporate managers in the 1920s, and investors showed a surprising willingness to purchase large amounts of nonvoting common stock, an increasingly vocal opposition also began emerging. William Z. Ripley, a Harvard professor of political economy, was the most prominent (or at least the most outspoken) proponent of equal voting rights. In a series of speeches and articles, eventually collected in a justly famous book, he argued that nonvoting stock was the "crowning infamy" in a series of developments designed to disenfranchise public investors.[20] In essence, this was an early version of the conflict of interest argument made below: promoters were using nonvoting common stock as a way of maintaining voting control for themselves.

The opposition to nonvoting common stock came to a head with the NYSE's 1925 decision to list Dodge Brothers, Inc. for trading. Dodge sold a total of $130 million worth of bonds, preferred stock and nonvoting common shares to the public. Dodge was controlled, however, by an investment banking firm, which had paid only $2.25 million for its voting common stock.[21] In January 1926, the NYSE responded to the resulting public outcry by announcing a new position:

Without at this time attempting to formulate a definite policy, attention should be drawn to the fact that in the future the [listing] committee, in considering applications for the listing of securities, will give careful thought to the matter of voting control.[22]

This policy gradually hardened, until the NYSE in 1940 formally announced a flat rule against listing nonvoting common stock.[23] Although there were occasional exceptions, the most prominent being the 1956 listing of Ford Motor Company despite its dual class capital structure, the basic policy remained in effect until the mid-1980s.[24]

Long before 1940, Ripley had proclaimed the demise of nonvoting common stock.[25] He was somewhat premature: in the years between 1927 and 1932, at least 288 corporations issued nonvoting or limited voting rights shares (almost half the total number of such issuances between 1919 and 1932).[26] But the Great Depression, with an assist from the opposition led by Ripley and the NYSE's growing resistance, killed off many disparate voting rights plans.[27]

Even so, however, dual class governance structures did not disappear. Far from it. Famous firms such as Ford and Hershey retained (as they still do) dual class capital structures. In the period 1988-2007, moreover, dual class firms held more or less steady at approximately seven percent of the total number of public corporations.

In sum, while their popularity has waxed and waned many times, neither dual class stock nor complaints about it are new. Granted, the one share-one vote rule fairly early became the default rule. But it remained only a default rule and departures from it remained common into the 1930s. Today's dual class capital structures thus were almost more of a revival of the historical norm than a departure from it.